Summary

A fourth fund, PIMCO NY Muni Income (PNF), may be susceptible to contagion risk because of its two sister NY funds listed above.

A member sent us a nice graphical illustration of muni CEFs plotting discount and NAV yield. While nice, it is too "simple" and tends to be as deep as many analysts want to dive. Even the analysis below only gets a few inches below the surface.

PIMCO released its monthly UNII and earnings report card on June 15th. It indicated to us that several distribution cuts to its municipal (tax-free) closed-end funds are possible. They may not happen on August 1st, but it is quite possible they may occur in the subsequent few months unless the trends change. History has demonstrated that PIMCO will not cut the distribution on its funds until it's absolutely necessary.

Unlike some other fund families, PIMCO UNIIs do not bounce around erratically (UNII is "undistributed net investment income" or income produced by the bonds but yet to be paid to the investor. It is a running balance since the inception of the fund).

With PIMCO, virtually every change month to month is no more than one penny per share up or down, and is often a fraction of a penny. This makes it easier to observe trajectories than using coverage ratios which tend to fluctuate to a much greater degree. Like most muni funds, a very high percentage of PIMCO holdings mature or are callable in the next 5 years. This means they are in a constant battle to replace the income lost from a redemption with new investments. Since they have a corporate policy of trying to maintain stable distributions, their ability or inability to replace that income dollar for dollar shows up in the UNII balance. In general, unless the dividend is deliberately cut and right-sized, the UNII balance trend will be slowly negative as high yielding bonds get replaced by lower yielding bonds. The question then remains: how long does each fund have until UNII declines, reaching a trigger point and a dividend cut is announced. This question is usually more critical for PIMCO than other funds because the market tends to bid PIMCO share prices up to much higher premiums, which means the crash from a cut can be jarring.

Across all 9 muni funds, the average UNII balance is currently 11 cents/share. Two months ago it was 13 cents, a year ago it was 15 cents, and two years ago it was 18 cents. The downward trends are unmistakable.

The Patterns We've Noticed

PIMCO's 9 muni funds are comprised of 3 Nationals, 3 for California and 3 for New York. One fund in each grouping has a very large UNII balance:

These three funds have maintained their payouts per share for nine years or longer. They have been the closest thing to a fixed coupon bond in a closed end fund package you could find. However, that also means they can't provide us with any clues about when PIMCO tends to cut. For that we need to examine the other 6 PIMCO muni funds, all of which have cut in the last 18 months.

We have noted several patterns regarding PIMCO distribution cuts:

A rapid acceleration in UNII decline (typically losing a penny or more per month for 4-6 straight months after a period of stability) almost always precedes the cut.

It's shown a willingness to delay or accelerate a cut if it can announce changes to multiple funds at the same time.

It has usually opted for large percentage "one and done" cuts of 20% or more as opposed to making smaller successive reductions every, say, 6 months.

Note that we have not stated that PIMCO cuts when UNII drops to X cents/share. That's because the UNII balance just prior to the most recent cut among these 6 funds was as low as -12 cents (PNI) or as high as +5 cents (PYN). In other words, the UNII trend has proven to be more critical than the absolute level of the UNII balance.

A Look at Each Fund

PYN (NY)

Last cut announced 2/1/17, -19.4%, announced in conjunction with changes at PNI, PMF and PMX.

Last cut announced 2/1/17, -23.5%, announced in conjunction with changes at PYN, PMF and PMX.

UNII trend prior to cut: dropped 11 cents in 8 months.

UNII balance low point prior to cut: -.12.

UNII trend since cut: major improvement in UNII balance (all the way back to zero), stable for the last year; last reported -$.02

Verdict: harder to read; rapid UNII decline has not occurred but negative balance could be enough for PIMCO to trim in order to announce simultaneously with PYN.

PNF(NY)

Last cut announced 2007.

From May 2016 to May 2017, UNII only dropped 2 cents, from $.30 to $.28.

But from May 2017 to May 2018, UNII dropped 13 cents, from $.28 to $.15.

Verdict: certainly meets the rapid UNII decline test but current "large" $.15 balance would normally suggest cut should still be a few months away; HOWEVER with coverage at only 80.5% we view it as possible that PNF gets cut despite this large UNII balance in order to announce changes at all 3 New York funds simultaneously. In trying to balance the needs of all 3 NY funds, it is unclear what date PIMCO will choose.

PCQ (CA)

Last cut announced 2008.

UNII dropped only 9 cents over the 19-month period spanning March 2016 to October 2017.

The decline is accelerating: UNII dropped another 9 cents just over the last 7 months (October 2017 to May 2018).

Verdict: certainly meets the rapid UNII decline test but current "enormous" $.52 balance suggests cut is a year or more away, even with coverage in the low 80s.

UNII trend since cut: UNII balance stable for the last 12 months, toggling between 5 and 6 cents.

Coverage only recently dropped below 100% to 95.7%.

Verdict: no cut predicted.

PML (National)

Last cut announced 2007.

UNII dropped only 7 cents over the 20-month period spanning March 2016 to November 2017.

The decline is accelerating: UNII dropped another 7 cents just over the last 6 months (November 2017 to May 2018).

Verdict: certainly meets the rapid UNII decline test, but current "substantial" $.28 balance suggests cut is a year or more away, even with coverage in the low 80s.

PMF (National)

Last cut announced 2/1/17, -26.6%, announced in conjunction with changes at PNI, PYN and PMX.

UNII trend prior to cut: dropped 6 cents in 4 months.

UNII balance low point prior to cut: -0.05.

UNII trend since cut: UNII balance recovered dramatically for the following 12 months, gaining 12 cents to +.07 at its peak in December 2017. Since then it has toggled between 3 and 4 cents.

Coverage only recently dropped below 100% to 99%.

Verdict: no cut predicted.

PMX (National)

PMX is the one fund that does not fit the "model" as evidenced above.

Last cut announced 2/1/17 was only -10.4%; it was announced in conjunction with changes at PYN, PNI and PMF.

UNII trend prior to cut: basically flat at zero.

UNII balance low point prior to cut: -.01.

UNII trend since cut: very stable for the next year, with UNII balance remaining in a tight range of zero to 1 cent; has dropped to -2 cents in the last 2 months.

Verdict: PMX doesn't fit the pattern of the other funds. Typically PIMCO waits for UNII to decline a penny per month for 4-6 months and then cuts dramatically. Last time, they didn't wait and cut PMX sooner, but smaller. The most recent two month's declines suggest PMX has started a descent. It wouldn't surprise us to see PMX incur a cut soon, once again both smaller and sooner, and announced in conjunction with the other funds noted above.

Conclusion

We follow PIMCO's coverage and UNII trends closely every month. Even though PIMCO is a timely reporter, it remains difficult to predict dividend cuts with a high degree of confidence. As much as one would like to buy and hold PIMCO muni CEFs "forever", PIMCO's preference for large, infrequent dividend cuts can create dramatic shocks to price and total return. One only needs to look at price graphs of PCK and PZC since they last announced cuts to see how damaging the sell-off can be to investors. For example, PZC plunged from selling at a 28% premium to NAV to trading at a slight discount over the course of 9 months. Clearly when investing in muni bonds, we are looking for safety, not opening ourselves up to double-digit declines in price and negative total returns.

The funds most susceptible to a near-term cut are PIMCO Municipal Income III, PIMCO NY Muni II, and PIMCO NY Muni III. Their UNIIs are currently down below zero and for reasons outlined above, we could see their dividends cut as early as July 2nd - especially if PIMCO wishes to "bundle the bad news". We believe that if PNI and PYN were to be cut together on the same date, there is a small chance that PIMCO NY Municipal Income gets trimmed as well in order to announce changes at all 3 New York funds simultaneously.

Because PMX and PNF currently trade at sizable premiums, investors need to be especially on-guard and attentive to PIMCO's monthly distribution announcements. While we risk exiting early, we would be sellers of both of these funds right now in order to capture the premium. If and when a cut materializes, and if it is large, we would not expect to buy back into the same names for many months. With respect to PNF, the play would be to sell this NY fund at a high premium and buy back into a different PIMCO NY fund selling at a discount (see below).

As for PNI and PYN, these NY funds currently trade much closer to NAV. Given their high current yields, it appears the market is already partially pricing in a distribution cut. Depending on the size of the next cut, we could see both funds swing to a discount of a few percentage points while the marketplace adjusts to the new, lower current payout. However, at least over the last 5 years, PIMCO muni funds have rarely stayed at a discount for long. If these funds sold off to, say, a -4% discount or more, we would be looking to add to our positions.